Category Archives: Real Estate ETF

During the 2008/2009 liquidity crisis property values in developed markets around the world fell 40-50%.

Also CRE ETFs have been affected and comparing the five European listed funds the pricing index (Jan 2007 = 100) shows the EPRA US Property ETF falling to an index -42 by March 2009. The strongest fall was experienced for the EPRA UK Property ETF to an index value of -64 in August 2009.

The first fund to react to the Lehman bankruptcy was the EPRA Developed market property ETF falling to -24 in Sept 2008, much earlier than any of the other property ETFs. The European investment property ETF IPRP shows less decline (lowest index level of -3 in Sept 2009) than the UK fund. This observation is consistent with actual property price observations in Europe such as Germany and France compared to the UK.

The fund that has performed best during the crisis was the EPRA Asia Property ETF with the lowest index level of 19 in Jan 2009.

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A quick look into 5 LSE listed real estate ETFs confirms Europe’s performance excl the UK is lagging behind due to unresolved economic and political issues.

Over a 3-year horizon the iShares FTSE/EPRA European fund (IPRP) has exhibited a correlation of 82% with the UK EPRA index, while the iShare FTSE EPRA UK fund (IUKP) has shown a close correlation of 85%. Europe’s fiscal austerity and tight credit conditions continue to add stress on the listed real estate sector with the latest casualty German property company IVG facing insolvency.

Week 5: Understanding risks of real estate ETF strategies

Counterparty risk is most often forgotten by fund investors, however, it exists an investment vehicles that lend out the fund’s constituents (securities lending). This is not only the case for many mutual funds but also synthetic as well as in physical ETFs. And the main providers of physical ETFs in Europe actually use securities lending.

Swaps in Synthetic ETFs

The use of swaps in form of total return swaps in synthetic ETFs causes additional counterparty risk in the structure of all synthetic ETFs. Because synthetic ETFs deliver the performance of the index they track via a swap contract normally with an investment bank as the counterparty whereby it exchanges the performance of such a basket for that of the index counterparty risk is intrinsic to their structure. This means that investors are irremediably exposed – at least theoretically – to the risk that the swap counterparty fails to deliver the performance of the index. While there may be multiple reasons why this may happen, the worst case scenario would be where the swap counterparty simply goes bankrupt. Irrespective of the cause, the ETF investor would be left with the contents of the “substitute basket” as collateral.

It is generally accepted that investors in synthetic ETFs are compensated for taking on swap counterparty risk with the reward of comparatively lower management fees, more accurate tracking vis-á-vis ETFs employing physical replication techniques or when actively managed it enables them to offer strategies such as multiple time the performance of an index.

Currency risk: Investors will most likely find a specific ETF offered in several currencies and different stock exchanges, which means there is no currency at that level. However, at the portfolio level the fund manager has to manage or hedge currency risk at the securities level when investing globally.

Risk mitigation

There are a series of regulatory measures that providers of synthetic ETFs must comply with as a means of protecting investors against this counterparty risk. Under UCITS rules, for example, the net counterparty risk exposure of an investment fund (i.e. not just ETFs) to any single issuer via a derivative (e.g. swap) cannot exceed 10% of its NAV. In effect this means that 90% of the ETF must be collateralised.

In reality though, the majority of synthetic ETF providers either fully or over collateralise their swap exposure on a voluntary basis, thereby increasing the level of protection afforded to investors. Furthermore, parallel to the voluntary enhancement of collateral requirements, providers of synthetic ETFs have also made major improvements in the area of transparency. For example, online disclosure – mostly on a daily basis – of the composition of the “substitute baskets” has become the norm. This level of transparency helps investors in synthetic ETFs to properly assess risk.

Securities Lending in Physical ETFs

Securities lending is the process of loaning assets to a third party in exchange for a fee. Some, though not all, providers of physically replicated ETFs have securities lending programmes in place with the objective of generating revenues that might partially, or in some cases completely, offset management fees and other sources of index tracking difference. Counterparty risk in this context arises from the fact that the borrowers of these assets might not return them to the ETF manager.

It is important to underline that, unlike the use of swaps for synthetic ETFs, securities lending is not a necessary practice for physical ETFs to deliver the performance of the index they track. Rather, the aim of a securities lending programme is to improve the ETF’s tracking performance. As such, exposing investors to the counterparty risk arising from securities lending becomes a matter of choice by ETF providers.

The level of disclosure around securities lending practices by providers of physical ETFs has improved substantially over the past couple of years. Some may argue it is not yet optimal. However, compared to the secrecy surrounding these practices in the actively-managed mutual fund industry, ETF providers can be fairly described as an “open book”.

In terms of protective measures, it has become common practice for providers of physical ETFs that engage in securities lending to either fully or over collateralise the loans. It is also important to note that while there is no regulatory limit to the amount a fund can lend out, some ETF providers have voluntarily adopted maximum on-loan limits. Some also offer indemnification (i.e. insurance) against potential losses.

The current analysis includes a total 47 real estate ETFs, which are being tracked in terms of their monthly performance, fees, yield and AUM.

After taking over the management of the Ishare universe Blackrock is by far the largest real estate ETF fund manager by number of funds with a market share of c38%, however by AUM Vanguard has a market share of 41% compared to Blackrock (35%). Although Vanguard does not offer many real estate ETFs it is managing the currently largest real estate ETF, which has a market share of 40% alone.

Figure: Fund Universe by Fund Manager

Source: Various, N. Lux, 2013

Most real estate ETFs are listed in the United States (c84%) and another c14% in Europe. As expected, also 68% of the funds have the U.S as their investment target, followed by 27% which focus on global strategies. Only 4% of strategies focus on Europe as an investment market.

Figure: Universe by investment target

Source: Various, N. Lux, 2013

Until now, 98% of real estate ETFs offered, follow a passive replication strategy. Most popular indices are subindices of the FTSE NAREIT or EPRA universe.

Figure: 10 Largest real estate ETFs

Fees

Fees are dependent on the fund manager and the investment strategy. Some smaller fund managers might not be as competitive in fees as larger ones. On average management fees are 46bps, with the majority being offered between 40-50bps. Within the same fund manager, the most popular fund will be offered at the lowest fees, while they might increase for certain other strategies. For example global strategies are typically priced slightly higher at 50-60bps.

Figure: 5 most expensive ETFs

Premium/Discount to NAV

ETFs typically trade very close to their NAV. Most real estate ETFs will be trading at a slight discount of 1-20bps. There are currently only 4 real estate ETFs which are trading at a premium.

Figure: 10 largest discounts

While the premium/discount for property shares is often an indicator of company size and liquidity, there is no correlation between ETF fund size and its discount/premium pricing. ETFs with the lowest discounts typically have their primary listing on the NYSE and have their investment benchmark focused on the United States. The few funds currently listed on the LSE appear to have the largest discounts.

In the previous session we have established that ETFs are in principal open-ended investment companies, whose shares can be traded on the stock exchange. (for a list of real estate ETFs traded on LSE download FTSE ETF)
In general investors are seeking diversified returns when they are looking to invest in a mutual fund such as a real estate securities fund. Investing in a mutual fund provides investors with exposure to a portfolio of assets in a specific sector or region.
Since 2000 a new style of mutual fund has entered the European market, the so-called exchange traded funds (ETF). Compared to a mutual fund they offer the following advantages:

they have a higher liquidity and can be traded on a stock exchange just like any other share. Thus, they are yet another product that offers real estate exposure on a highly liquid basis for an otherwise illiquid asset class

However, in some other aspects they are more similar to Property Unit Trusts (PUTs) than real estate securities funds.
Any investor who has mastered the understanding of Property Unit Trusts, will see the similarities and find the ETF structure easy to understand.
Just like the PUT, the ETF issues or creates units based on the NAV of the underlying portfolio. The difference is that the shares of an ETF can be traded throughout the day on the exchange and the portfolio does not consist of physical properties but shares of property companies or REITs.
Figure: Physical ETFsSource: N. Lux, 2013
This also means that the price of an ETF share on the stock exchange is subject to the forces of supply and demand and the trading price can be different to the fund’s NAV.
When the ETF creates new units it issues bundles of shares, which are being bought by the “authorised participant”. This participant can be a market maker, broker, large institutional investor etc, who is then trading individual shares on the stock exchange.
Because the trading price does not completely reflect the NAV, ETFs behave more like an individual share than a mutual fund, which is investing in property company/REIT shares. However, ETFs have different liquidity levels themselves and the more liquid ETFs are expected to trade very close to their NAV.
Table: Example trading price vs NAV
Also for mutual funds there are differences in pricing, for example an open-ended fund (i.e. PUT) will trade equal to its NAV while a closed-end fund can trade at a premium or discount (discounts are expected to be larger than for ETFs).

Portfolio setup and strategies

The ETF itself originates with a sponsor, meaning the company or financial institution which chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways.
1. A replicate index-based ETF holds every security in the target index and invests its assets proportionately in all the securities in the target index.
2. A sample index-based ETF does not hold every security in the target index; instead, the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities.

Target indices include:

US Indices

Cohen & Steers Realty Majors Index

Dow Jones U.S. Real Estate Index

Dow Jones U.S. Select REIT Index

FTSE EPRA/NAREIT North America Index

FTSE NAREIT All Mortgage Capped Index

FTSE NAREIT All Residential Capped Index

FTSE NAREIT Industrial/Office Capped Index

FTSE NAREIT Real Estate 50 Index

FTSE NAREIT Retail Capped Index

IQ US Real Estate Small Cap Index

KBW Premium Yield Equity REIT Index

Market Vectors Global Mortgage REITs Index

MSCI US REIT Index

S&P United States REIT Index

Wilshire U.S. Real Estate Investment Trust Index

Morningstar Real Estate Index

Other Indices

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+

FTSE EPRA/NAREIT UK Index

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

Both of these replication methodologies are called physical ETFs. In addition to the physical ETF there are so-called “synthetic” ETFs, which deliver the index performance via a swap contract. The total return will then be delivered by the swap contract, while the cash in mainly invested in low risk collateral such as zero coupon bonds, which were acquired at a discount or government bonds.
Figure: Synthetic ETF

Source: N. Lux, 2013
Real Estate ETFs are currently mostly physical ETFs, meaning they invest in a basket of physical securities. We will analyse the different risks related to these strategies in the next session.

Follow this weekly blog to broaden your knowledge on real estate ETFs.
The following series of six essays/notes will discuss structures, risks and investment quality of property ETFs and assess their suitability to gain real estate exposure from an investor’s point of view.

Week 1: Introduction

Over several decades now it has been one of the primary goals of the real estate investment industry to find new ways to make real estate investments more liquid. Efforts started with increasing market transparency for the physical asset and fund investing directly in the physical assets by

Introducing performance/benchmarking measurement

Making transaction data more available through databanks

Making portfolio data including valuations available in fund prospectus and fund audit reports

Multiple ongoing discussions have also been held on finding the optimal fund structure.

There are two main types of fund structures: open-ended or closed-ended. Closed-ended funds include investment trusts, real-estate investment trusts (REITs) and property funds traded. The closed-ended structure makes life simpler for fund managers, as they do not have to deal with inflows and redemptions (avoiding forced selling in a falling market). Closed-ended funds also allow higher gearing levels (debt-equity ratio) to boost returns, although gearing exacerbates losses in a falling market, as seen during the last crisis 2007/08. The major downside of the closed-ended structure is that a fund’s shares can trade at a discount or a premium to their true net asset values (NAVs), and there is typically hardly any secondary market to trade these shares. Open-ended funds include property unit trust or OEIC (open-ended investment companies). The fund manager creates or cancels units that investors buy or sell. The pricing of units typically happens ones per day and directly reflects the value of the underlying assets. Fund-of-Funds are fund managers who invest in other closed-ended funds. They can offer superior diversification, but are more passive as they don’t directly manage the underlying assets. They also belong into the category of closed-ended funds.
Both closed-ended as well as open-ended fund structures have been criticised at different points in the property cycle. Closed-ended funds have been found too illiquid and inflexible as it is difficult for investors to exit from them. Open-ended funds, which are supposed to be more liquid also had their problems managing redemptions, and some were found to close due to large money outflows in a down-market. However, from 2000 onwards it wasn’t just about different fund structures but totally new products have also emerged in the European market:

commercial mortgage backed securities

property derivatives

property notes

property ETFs

Like unit trusts and OEICs, ETFs are open ended investment companies, meaning that you can buy or sell their shares, however the shares are much more liquid as they are being traded on the stock exchange on an intraday basis. Hence, the difference to a property securities fund or PUT is that their trading price differs from the underlying NAV. The price of an ETF share on a stock exchange is influenced by the forces of supply and demand.
Figure 1: Basic ETF structureSource: Nicole Lux 2013
The market of ETFs has especially grown in other sectors such as commodities, equities, fixed income, currencies. They are used by retail and institutional investors alike.